Archive for the 'Coase theorem' Category

P. H. Wicksteed, the Coase Theorem, and the Real Cost Fallacy

I am now busy writing a paper with my colleague Paul Zimmerman, documenting a claim that I made just over four years ago that P. H. Wicksteed discovered the Coase Theorem. The paper is due to be presented at the History of Economics Society Conference next month at Duke University. At some point soon after the paper is written, I plan to post it on SSRN.

Briefly, the point of the paper is that Wicksteed’s argument that there is no such thing as a supply curve in the sense that the supply curve of a commodity in fixed supply is just the reverse of a certain section of the demand curve, the section depending on how the given stock of the commodity is initially distributed among market participants. However the initial stock is distributed, the final price and the final allocation of the commodity is determined by the preferences of the market participants reflected in their individual demands for the commodity. But this is exactly the reasoning underlying the Coase Theorem: the initial assignment of liability for damages has no effect on the final allocation of resources if transactions costs are zero (as Wicksteed implicitly assumed in his argument). Coase’s originality was not in his reasoning, but in recognizing that economic exchange is not the mere trading of physical goods but trading rights to property or rights to engage in certain types of conduct affecting property.

But Wicksteed went further than just showing that the initial distribution of a commodity in fixed supply does not affect the equilibrium price of the commodity or its equilibrium distribution. He showed that in a production economy, cost has no effect on equilibrium price or the equilibrium allocation of resources and goods and services, which seems a remarkably sweeping assertion. But I think that Wicksteed was right in that assertion, and I think that, in making that assertion, he anticipated a point that I have made numerous times on this blog (e.g., here) namely, that just as macroeconomic requires microfoundations, microeconomics requires macrofoundations. The whole of standard microeconomics, e.g., assertions about the effects of an excise tax on price and output, presumes the existence of equilibrium in all markets other than the one being subjected to micro-analysis. Without the background assumption of equilibrium, it would be impossible to derive what Paul Samuelson (incorrectly) called “meaningful theorems,” (the mistake stemming from the absurd positivist presumption that empirically testable statements are the only statements that are meaningful).

So let me quote from Wicksteed’s 1914 paper “The Scope and Method of Political Economy in the Light of the Marginal Theory of Value and Distribution.”

[S]o far we have only dealt with the market in the narrower sense. Our investigations throw sufficient light on the distribution of the hay harvest, for instance, or on the “catch” of a fishing fleet. But where the production is continuous, as in mining or in ironworks, will the same theory still suffice to guide us? Here again we encounter the attempt to establish two co-ordinate principles, diagrammatically represented by two intersecting curves; for though the “cost of production” theory of value is generally repudiated, we are still foo often taught to look for the forces that determine the stream of supply along two lines, the value of the product, regulated by the law of the market, and the cost of production. But what is cost of production? In the market of commodities I am ready to give as much as the article is worth to me, and I cannot get it unless I give as much as it is worth to others. In the same way, if I employ land or labour or tools to produce something, I shall be ready to give as much as they are worth to me, and I shall have to give as much as they are worth to others-always, of course, differentially. Their worth to me is determined by their differential effect upon my product, their worth to others by the like effect upon their products . . . Again we have an alias merely. Cost of production is merely the form in which the desiredness a thing possesses for someone else presents itself to me. When we take the collective curve of demand for any factor of production we see again that it is entirely composed of demands, and my adjustment of my own demands to the cond ditions imposed by the demands of others is of exactly the same nature whether I am buying cabbages or factors for the production of steel plates. I have to adjust my desire for a thing to the desires of others for the same thing, not to find some principle other than that of desiredness, co-ordinate with it as a second determinant of market price. The second determinant, here as everywhere, is the supply. It is not until we have perfectly grasped the truth that costs of production of one thing are nothing whatever but an alias of efficiencies in production of other things that we shall be finally emancipated from the ancient fallacy we have so often thrust out at the door, while always leaving the window open for its return.

The upshot of Wicksteed’s argument appears to be that cost, viewed as an independent determinant of price or the allocation of resources, is a redundant concept. Cost as a determinant of value is useful only in the context of a background of general equilibrium in which the prices of all but a single commodity have already been determined. The usual partial-equilibrium apparatus for determining the price of a single commodity in terms of the demand for and the supply of that single product, presumes a given technology for converting inputs into output, and given factor prices, so that the costs can be calculated based on those assumptions. In principle, that exercise is no different from finding the intersection between the demand-price curve and the supply-price curve for a commodity in fixed supply, the demand-price curve and the supply-price curve being conditional on a particular arbitrary assumption about the initial distribution of the commodity among market participants. In the analysis of a production economy, the determination of equilibrium price and output in a single market can proceed in terms of a demand curve for the product and a supply curve (reflecting the aggregate of individual firm marginal-cost curves). However, in this case the supply curve is conditional on the assumption that prices of all other outputs and all factor prices have already been determined. But from the perspective of general equilibrium, the determination of the vector of prices, including all factor prices, that is consistent with general equilibrium cannot be carried out by computing production costs for each individual output, because the factor prices required for a computation of the production costs for any product are unknown until the general equilibrium solution has itself been found.

Thus, the notion that cost can serve as an independent determinant of equilibrium price is an exercise in question begging, because cost is no less an equilibrium concept than price. Cost cannot be logically prior to price if both are determined simultaneously and are mutually interdependent. All that is logically prior to equilibrium price in a basic economic model are the preferences of market participants and the technology for converting inputs into outputs. Cost is not an explanatory variable; it is an explained variable. That is the ultimate fallacy in the doctrine of real costs defended so tenaciously by Jacob Viner in chapter eight of his classic Studies in the Theory of International Trade. That Paul Samuelson in one of his many classic papers, “International Trade and the Equalization of Factor Prices,” could have defended Viner and the real-cost doctrine, failing to realize that costs are simultaneously determined with prices in equilibrium, and are indeterminate outside of equilibrium, seems to me to be a quite remarkable lapse of reasoning on Samuelson’s part.

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About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey's unduly neglected contributions to the attention of a wider audience.

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